Let’s Buy a Foreclosure Together! … Episode 1

You and I are about to embark upon an adventure together over the next few months!

Have you ever wondered what is involved in buying a bank-owned home at a massive discount, renovating it back into nice condition, and then selling or renting it out at a highly profitable rate? Well, a friend and I are about to do just that, and I’ll be documenting everything right here on MMM so you can vicariously enjoy and judge our progress while you learn from the Masters.

All of us are well aware that the US housing market has been in a very funky state for several years now. Some people have treated this as source of fear, noting that their own house is now worth less than what they paid for it, and perhaps less than what they owe on it.

Other people (like me) have watched with some fascination as banks have offered up foreclosed homes at ludicrously low prices around their towns, and lucky investors have snapped them up within a day or two. With a wife who is a licensed real estate agent, and being an enthusiastic home builder/renovator myself, I typically run the numbers on each of these houses on the day it goes up for sale, determine how much profit could be made with a reasonable amount of restoration work, then sit back and watch as another investor buys the house and re-sells it a few months later, claiming the profit that I could have had if I had gotten off my own butt.

My excuses so far have been that “I don’t really need to earn more money”, “I don’t want to compromise my family time with a big outside project”, and “I insist on buying all future houses with 100% cash”, because involving a bank, appraiser, insurer, and all of their attendant fees and delays tends to reduce the joy of real estate dealings for me. By sometime next year, I will have enough uncommitted cash to buy a low-priced home in my neighborhood and do everything my own way without a loan, so that’s what I’ve been waiting for.

But in the mean time, I am missing out on some real FUN. I would love to be part of a big high-speed high-profit renovation project right now. The deals won’t last forever (filings are down 50% from their peak here in Colorado, although it will still take a few years for banks to clear out their backlog). And with the rental market being quite strong these days, it’s a good time to be a landlord.

It is fascinating to me to evaluate an old and junky house, then strategically design some changes that will dramatically improve the feel of the home.”Open up this wall to expand the kitchen, paint the whole interior and exterior in clean and rich historic colors, add a big window here, rebuild this old bathroom, and add a second bathroom over in that back room”. Things like that.

When you take the sale price of some of these bank-dumped homes, and then design a budget for any necessary renovations or restorations (many of them are in pretty scary condition due to months/years of neglect), and compare it to recent sales prices in the same neighborhood, the potential for profit is often huge. My own calculations show profits of $15,000 – $40,000 for a 6-month project, even after paying for the renovations separately. So the investor earns this amount purely for the process of buying, and later re-selling, the house. Alternatively, I’ve calculated about a 15-20% net annual return on investment if you put 20% down on a $115,000 house in my ‘hood, and then rent it out at market rates. (Now you see why Mr. Money Mustache is pretty confident about getting annual returns of 7% on his savings over time – because some of it earns higher rates like this!)

To help get my fix of the house scene, I’ve been helping an investor friend of mine in the neighborhood to find another rental house to add to his collection. We have rushed out and toured several houses on the first day they came to market, and made above-asking-price offers on the same day. But so far, we’ve been outbid every time. It’s because the banks are selling at unnecessarily low prices, and the other investors who are competing with us know it too. Each investor tries to out-guess everyone else by offering more than the asking price, but still enough below the actual market value to ensure a healthy profit margin. We have failed to win this mental lottery so far.

But this week, it looks like we got lucky.

On September 2nd, a bank-owned home came up only three blocks from our own houses. My friend and I both live in a mixed historic neighborhood where the fair market value of houses ranges from $150,000 for an unsightly shack up to perhaps $500,000 for a stately 5-bedroom victorian brick house. Sales have been plodding along steadily since the housing crash – in our area, we never got the mid-2000s boom, and we barely got the subsequent bust. And it is probably the most desirable neighborhood in the city, with limited supply and gradually increasing demand making it one of the most stable housing markets around. Families and stylish hipsters want to buy the houses that are already in nice condition, but only us grungy contractor/investor types are competing for the dumps, which gets us some good deals.

The house in question is above the “shack” level, it could probably be considered a “historic cottage”. It’s about 80 years old, with 2 bedrooms/1 bathroom, 900 square feet, on a really nice large lot with trees, an awesome back deck with hot tub, and a detached 1-car garage facing an alley. Fair market value as assessed by the city: $180,000. Bank asking price: $110,000. Current cosmetic and maintenance condition: Very Shitty.

My friend made a bid on the house at the full $110k. It was rejected by the bank – they had other offers. He raised it to $115k. Still rejected.

Two weeks later, the bank came back to us – the first sale had fallen through as the buyer backed out. We re-iterated the $115k offer — and got it!

This house will generate a hefty profit for my friend – and since I’m investing a portion of the purchase price and doing some of the renovation work – some nice profits for me too. Here is my forecast for how things will work out.

Purchase Price: $115,000
Renovation materials and labor (the place needs a new bathroom and a kitchen upgrade, plus plenty of paint, some roofing, and landscaping): $25,000
Total Cost after upgrades: $140,000

This is an annual capitalization rate 0f 8.3% after expenses. Quite good for a single family rental house. We’re buying the house with old-fashioned cash, with a portion of it being from me.

Just for comparison, here’s how the numbers would work out for someone buying this house with a traditional 80% loan at 4.5%, rolling in the renovations and additional closing costs that typically come with a loan:

Note that since both the value of the house and its rental income will on average go up with inflation, this is actually a 16.8% inflation-adjusted return. Of course, you do have to take care of tenants and keep the place occupied and avoid vacancy, but after doing this for many years my friend and I are both comfortable with the trade. On an hourly basis, it is very highly paid work.

This is just the first installment in this dramatic series. The closing date for this sale is October 25th. On that day, we could turn around and re-list the house without any changes for an instant sale at around $140k, but instead we will dig into it and transform it from Zero to Hero in about two months, then find a responsible tenant to move in!

I’ll publish before, during, and after pics and describe some useful projects we’re doing within on a series of MMM articles. We can cover things such as how to re-build a bathroom and a kitchen, how to do your own plumbing, interior design techniques, how to advertise a rental house, and surely many more as we go through the house.

Since this is the Mr. Money Mustache blog, we will be doing it all with an eye for Ultimate Efficiency – creative use of materials and design, using nearly-free supplies from the recycled building materials yard when possible, and a 100% Insourcing model with respect to doing the work.

It will be loads of fun. And it may even inspire some of you who were on the fence, to take the plunge into house-related profits in one way or another. Maybe renovating your own house, or buying your first one, or owning your first rental property.

Update: Here’s a Neat Spreadsheet for analyzing rental house income, emailed by a reader as part of the discussion below. SFH_Rental_Analysis

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This has just become my new favourite MMM article (there are many to choose from)! I am so excited about seeing the life cycle of this project, I wish your closing date was even sooner. I plan to undertake a similar adventure next year, assuming the housing market in the US is still nice and shitty, so this will be a perfectly timed how-to. Thanks, MMM!

I would love to do this exact thing. I’m waiting on us getting our student loans paid off first, and I’ll probably tackle it with 20% down. I still own our old house, and am renting it out right now, but I’d love to have multiple rental properties. We renovated the kitchen and bathroom in that house, and everyone that walks through it loves it!

I’m excited to read the rest of your series about this, as it’ll give me some more motivation for a couple years down the road when I can go through it myself.

The only thing missing from your calculations is ongoing maintenance expenses. We rent out a couple of houses, and just like any other house, they need periodic repairs, maintenance, and upgrades. A deck needs repainted. Carpet needs replaced. An appliance needs fixed or replaced. Etc.

It’s tough to build those costs into an “annual rate of return” number, because they are sporadic and inconsistent. But they also can’t be ignored.

So I’m curious how you plan to incorporate those expenses into your figures…?

That’s a good question. For a house in standard condition, you might end up with an average of $200 in maintenance costs per year. On the other hand, everything will be spiffy and new after this renovation, so we’ll probably get a 5-10 year honeymoon period with much lower maintenance initially.

Also note that I didn’t budget in the PROFIT from buying and fixing this house in my rental estimates. We’re putting in $140k, but by the time we turn it over to the first tenant, the house will be worth close to $180k because it will be in great condition. This $40k profit will be realized when he eventually sells it. But if you mentally account for that over a 10-year rental period, it is actually adding $4k per year to your returns – far more than any maintenance costs you’ll incur.

There are many factors of profit and expense in a project like this – instead of calculating them all perfectly, I tend to just focus on having a big safety margin like that $40k, so it’s almost impossible to lose. This is accomplished by learning your own local market intimately by watching every listing and sale (I’ve done this for the past 6 years), so you can recognize a good deal.. then buy one of those good deals!

Very cool. I’m actually closing on a foreclosure on Thursday. I’ll be writing up a similar post after I close.

Like you, I’m less worried about the income as I am the experience and the fun that should come with it. The house is a complete disaster, so it will be fun to watch it improve. I’m working with a partner, so I’ll be able to learn from her years of experience.

We’re contracting out all the work since I don’t have time to do it right now (and my partner doesn’t want to hold it as long as it would take for me to do the work.)

We’re also flipping, rather than renting. I’m interested in renting eventually, but my partner just wants fast cash and I’m learning from her. As for calculating your rental returns,make sure you account for about 10% maintenance and also derate 10% or so for unoccupied months. Hopefully you won’t need it, but it gives you a margin of error.

By the way, have you worked out paperwork with your friend? Specifically, do you have a joint venture agreement or LLC to protect yourself?

I think adding a 10%/10% budget for maintenance and vacancy is another good form of safety margin, especially for a beginner. I’ve never come close to these figures myself (I’d say maintenance is more like 1% of rental income), and I’ve never had a single month of unwanted vacancy in any property.. but a landlord should always be prepared for the worst case – for example, I wouldn’t personally own a rental if I couldn’t easily cover a year’s worth of vacancy without major worry.

My friend and I have a nice safe agreement. I’ve been burned in a major way in the past, so I do agree that people should be careful when teaming up financially with friends. In fact, I’d recommend avoiding it to most people for your first venture – just wait until you can do everything under the control of one person. You can still pay a friend as a contractor or consultant if you want to get their skills involved.

I woke up early this morning, and spent way too much time on Zillo looking at houses to buy, fix, and rent. So I was happily surprised to see this blog entry.

I’m very interested in watching the progress from start to finish! Could you talk some more about the process of finding the right house? Things like more detail of the discovery process, what repairs are too much to bother with, etc?

Awesome! I’ll read every detail of this new post series as I am interested in buying a foreclosure eventually.
Inspired by your recent post about insourcing, my husband and I decided to install a tile kitchen backsplash last weekend. Though we made some mistakes during the project, we are now backsplash experts… not to mention our kitchen looks beautiful!. We feel empowered now to start our next D-I-Y home improvement project: changing our flooring from carpet to wood laminate.
By the way, I love the kitchen in the picture. It is definitely my stile: modern and minimalist.

I love this! I had to restrain myself from pulling up the MLS site when I was only halfway through reading your article.

We live in a neighborhood in Mpls where there are excellent deals – and near to the University and many shops/nightlife/buslines.

Only thing is, I have no experience with the renovations. My dad however, is an expert, and has been building houses for 30 years. I’ve been trying to convince him to go into business with me, I would apprentice with him and do all the business/landlord type stuff….

I am looking forward to reading about your journey MMM. I love this blog!

My husband and I just bought a foreclosure (HUD) last July. It needed just a little bit of work, which was perfect for our first one. We rented it out to great tenants and are are now hooked. We can’t wait to buy the next one.

I found this great spreadsheet to easily crunch the the numbers on a property…..

If you want to know if you are getting a good deal, (and don’t have access to the mls), redfin.com is a great tool for looking at comps.

I would be interested to know where to find the foreclosures not in the mls. I am getting emails from trulia about foreclosures, with street name but no number. I’m not even sure if these properties really exist or how to find out more about them. Like Matt, I’m wondering is foreclosure.com worth it, or is their a more mustachian method to get this info?

Thanks Tripolty – hey, if you have access to that spreadsheet, would you mind emailing it to me at mmm at mrmoneymustache.com? The biggerpockets site seems to be asking me to register before it will let me see the spreadsheet. If it’s good, and allowed to share with everyone, we can share it here with no registration needed.

Regarding getting foreclosures before they actually come to market – I don’t have much experience with this. I know that each property goes up for auction at some point in the legal proceedings, and the bank that owns the lien will typically be there to bid for it. As an investor with cash, you too can be there for the bidding, which might get you a deal earlier. The downside of this is, you may not have a chance to personally view the home before buying it.

In the current market, foreclosures are much more common than they were before the housing crash (30% of sales these days are foreclosures nationwide!). So it’s pretty easy to get one using the regular listing system. And as an added bonus, once properties are on the open market, the sale is very easy to deal with – you can get financing, you can ask the bank to replace the roof for you before closing, etc.

To give me the advantage of speed, I just had Mrs. Money Mustache, who is secretly a high-tech real estate agent, set me up with an automated “Mysite” monitoring website which emails me immediately when properties come to market with my search criteria. I also get an email whenever anything sells, so I can watch the sales trends/prices.

I have a feeling that this will be my favorite MMM series yet! I don’t have the funds to get into the market now but with some serious saving and thriftiness, I hope to be ready soon. I’m sure this article series will help me motivate to save even more!

You really need to read the 50% rule and 2% rule. Go to the biggerpockets site linked earlier and search their forums.

This house is cash flow negative with 100% financing (and the many issues you are ignoring like maintenance/repairs, vacancy, management, etc), meaning forcing cash flow by paying cash is a low return on your investment.

Like I mentioned to you in an earlier email, the wife and I own a few rental houses, I’ve done a lot of reading on the subject.

I’d be happy to discuss more over email or the phone if you’d like to. I don’t have anything to pitch to you, just a reader that would be happy to share, cause I’ve enjoyed your site so much for the past 6 months or so.

It would be extremely positive even with 100% financing at 4.5%. I appreciate your feedback and would love to hear more tips that would help me and fellow landlords learn more about profitable rentals. But I know many millionaire landlords, including myself, who have gotten quite wealthy with properties with considerably lower cap ratios than the one described in this article. So where’s the problem?

I did check out some forum comments by searching around on biggerpockets.com – couldn’t find any coherent arguments to disprove what I’ve stated here so far. But as usual, I DO like to be proven wrong, so share more if you’ve got it.

Hi MMM. You usually advocate leaving very little money un-invested (a dividend paying stock fund– VFINX, etc). How do you balance this recommended approach with having cash to buy another house cash? You clearly have plenty of non-volatile liquid assets you are not afraid to tap.

I have systematically invested in either dividend paying stock funds or stocks themselves, at the expense of having very little cash to buy anything mayor at a whim’s notice. Every time a great deal comes along I have to take into account what my current gains (or losses) are and if it’s worth to take the capital gains hit.

Perhaps you can pontificate on how much stable liquid assets to have as a percentage of one’s portfolio (cash/bonds/etc)?

That’s a great question Gypsy Geek. The answer is asset allocation. Leaving some of your AA in cash/CDs hedges against certain risks, and also leaves you what is called “dry powder” to allow you to take advantage of opportunities.

MMM, I’d love to address this comment with a guest post (and then you can add in your thoughts on why you had that much cash in your portfolio personally). LMK. :D

Doesn’t having a big portion in cash, mean you have to account for pretty much a 1-2% return (pre-inflation even) on that amount (CD’s/etc). This would mean you would need even more money to retire, or do you assume this money will be reinvested soonish? Just curious… I’m a compulsive investor and am always at cross-roads when determining whether I should leave things in cash or invest. Again, just curious.

I will admit I had to look up “AA” (Asset Allocation) and “LMK” (Let Me Know) to understand this response. Am I old-fashioned for enjoying the typing out of Full English Words? I would personally die a gruesome death before I would ever write “DW” instead of “My Wife”, or “ur” instead of “your” or “you’re”. On the other hand, It’s totally normal to write SWAMI for Satisfied Working Advanced Mustachian Individual, and MMM for Mr. Money Mustache. :-)

So anyway, regarding the Asset Allocation Guest posting, I’d say “GO JOE!”. As for cash in my own portfolio – I don’t have nearly that much right now, but I thought I’d let it start to accumulate until next year, and then it will be ready for some Fix’n’Flipping. Also, some of it will come from an existing line of credit on my own house, rather just $100k plus of Idle Employees. Lines of credit are magical, because you get the Dry Powder without the Carrying Cost. The reason for any sort of cash reserve, just as Joe says, is for Exciting Opportunities (including buying stocks right after enormous stock market crashes, if the valuation is right, in my opinion).

Aww.. thanks, I am honored that you would feel like investing with MMM, Inc. In this case, I’m mainly doing this project because it is a way to have fun with a friend, it’s right near my house, and it will be an entertaining thing to write about. Taking on even more projects with more investors would become too much like a traditional job!

One thing that WOULD be quite fun, however, is to be a consultant for someone working their way through the process for the first time. Working together over email/phone/skype to help choose properties, estimate rents and renovation ideas, write up the advertisement to find tenants, etc. All on a no-contract hourly basis. I might try that out if the chance came up. So many fun work ideas, so little time!

Hi MMM! I’m quite aware that you have exponentially more humans asking you questions and trading emails with you than 2011-MMM did, but since you mentioned the idea here….

I just bought an old-school all brick duplex in St. Louis, MO (we live here in part due to the great affordability of real estate and cost-of-living) and would love even a few minutes of your consulting time via email or skype. My wife and I are both 26 and first-time home buyers/renovators. Planning to fix up one unit, rent it out, then do some renovation on the other unit whilst we live in it. It would be super-helpful to send you some pictures of the current outdated interior and get expert advice on where you would start (e.g., destroy that 1960s bathroom with reckless abandon and visit ___ website for instructions on how to rebuild). Any and all general advice or pointers in the right direction would be awesome. Again, I know you’ve got some fun construction work of your own these days, so no worries if there’s no time for trading emails. The home renovation project shall be a kickass and profitable experience one way or another. In the meantime I’ll continue poring over the many brilliant renovation how-tos already in these archives and the MMM forum. Cheers from a devoted mustachian!

Very good article. I am in the process right now of buying a foreclosed home as my first house. It is a buyers market right now, the home I’m purchasing is $23k under as-is appraised value and about $43k under appraisal value after renovations and fixing. Renovations and the small fixing it needs should come in around $7k-$10k as I got lucky and got a property that the previous owners actually seemed to halfway care about and took some care of it.

I was paying $1000 a month to rent a smaller house and my mortgage note should easily be half. Factor in my fiance and I doubling up (or more) on notes since we have the extra money to do so and we should have things squared away within 10-13 years. Hopefully we will be shaving our bills down by $500 just from purchasing a home.

I just recently found your site and will definitely have to read more of it. You seem to have a lot of good tips. Your article on the recent power loss we interesting as living in the south I went through the same thing during a hurrican. Being without power for 2 weeks was miserable in the heat, but you learn a lot about yourself.

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